Tuesday, 21 June 2011

Dual Class Shares - Are they Ok or to be Avoided?

One person, one vote is a fundamental principle of democracy. Presumably it should also apply in stocks as one share, one vote. After all, if one takes the risk of owning common stock, it is only right that there should be an equal say in the affairs of a company. Yet that is not the case amongst many companies listed on the Toronto stock exchange which have two classes of common stock, one with lesser or no voting rights and the other with multiple or all voting rights. As of February 2011, there were 83 such companies, or about 6% of TSX listings, according to papers posted on the website of the University of Toronto's Capital Markets Institute. Very often the reason invoked to create dual shares is to allow continued founder control over a company to keep it growing and to maintain a long-term outlook while injecting new equity capital instead of debt financing.

Dual Class - Not Automatically Bad!
It is not necessary for the individual investor to automatically bypass such shares. The most recent substantial - and impartial - research on the subject by Ben Amoako-Adu, Brian F. Smith, Vishaal Baulkaran of Wilfrid Laurier University (paper available here from the CMI) notes that "Investors in dual class companies do not earn a lower risk-adjusted return than those in single class companies with concentrated ownership". Their recommendation upon studying thirty-two companies that unified (eliminated) dual class shares in Canada from 1989 to 2010 is that they nevertheless serve a useful role: "Dual class shares should continue to be issued to finance growth without the fear of losing control until the firm is matured".

Caveats - The Devil in the Details
Dual class share structures are not always good however, and the researchers' additional recommendations tell us key features to watch out for since, unsurprisingly, rights and privileges of the "lower class" shares can and do vary considerably, as we show below.
  1. Coattail protection - These rights allow holders of non‑voting or restricted-voting shares to participate equally with the holders of the superior‑voting shares in a formal company takeover bid for superior-voting shares i.e they get the same deal. The TSX made this condition a requirement for new listings as of 1987 but older companies got a grandfather clause exemption. Some of the exempt companies are Rogers Communications Inc., Astral Media Inc. and Shaw Communications Inc.
  2. Maximum 10:1 Voting Ratio - The superior shares should not have more than 10 times the vote per share of each subordinate share.
  3. No Non-voting Shares - Each share should have some voting rights, though limited.
  4. Sunset Clause Upon Founder Retirement - Since dual class shares often come about in companies with a founder-owner, it is a good idea to set an end to the dual class shares at a time when the structure should no longer be useful or necessary for company progress. Moreover, the terms and conditions for special compensation of the founder should be written down. This condition might be called the Frank Stronach test for the outrageously high payout ($983 million or 2063% return according to the authors) the Magna founder and controlling shareholder extracted from the company upon its conversion to a single common share class in 2010.
Conversion Bonus - Speculative Opportunity
Researchers have also found that amongst the actual conversions from dual class structure to single common class, subordinate shareholders benefited by an average 8% increase in stock price upon conversion. Ironically, "... the worse the job that the controller does, the greater the buyout premium!" according to Prof. Jeffrey MacIntosh of the University of Toronto in this presentation. Those who wish to engage in stock speculation can buy shares in badly run companies in anticipation of a conversion to single class since elimination of the dual classes will cause improved management and higher profits.

Example: Dual Class Shares Amongst Dividend Growers
We came across a number of dual shares in our recent postings on stocks with the attractive feature of growing dividends - the Low-Yielders and the High-Yielders. That gives us ten companies to compare in terms of the voting privileges, controlling shareholder, rights of subordinate shareholders, governance rating (from the Clarkson Centre for Business Ethics and Corporate Governance), 5-year dividend growth and 5-year total stock appreciation and dividend return. As a rough benchmark for returns, we include the performance of the popular iShares S&P TSX60 ETF (symbol: XIU).

  • Best Returns Have Worst Protection - Rogers and Shaw look to have the most ominous rights for the subordinate shareholders yet the returns for both are the best in our table and exceed XIU's by a good margin. Go figure.
  • Best Rights Have Excellent Returns - Metro has the best minority rights, in fact the subordinate MRU.A shareholders, control almost all the votes. Metro also exhibits excellent performance, beating XIU in both dividend growth and total returns.
  • Occasional Extra Dividends for Subordinate Status - Some companies - CCL, Corus, Shaw and ShawCor - offer more dividends to subordinate shares than to the controlling shares.
  • Take Your Pick of Voting or Non-Voting - Many of the companies have both classes of shares available for public purchase on the TSX, though the dominant / multiple voting shares trade in much smaller volumes. What is not feasible for institutions who need high volume liquidity may be accessible and possible for an individual.
Finding Info on Dual Class Shares
  • Companies - There seems to be no ready-made source list of the afore-mentioned 83 dual share companies in Canada. Such shares can however be identified by a suffix - .A or .B or .X - attached to a ticker symbol. There is no convention for whether the subordinate shares should have .A or .B. As we saw in the sample stocks, it is easy to find both.
  • Share Structure and Rights - To find out the rights for each class of shares, go to Sedar Search Database and pull up the Annual Information Form for the company, then within it go to the part on Share Capital Structure.
Bottom Line
The biggest lesson is that subordinate rights vary a lot from company to company. When considering a company's shares, along with the prospects and position of the business itself, proper due diligence must consider the share structure and the rights of each class.

Further Reading:
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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